Here’s Why the Government Wants Inflation

Source: http://www.flickr.com/photos/ash_crow/

Government officials and central bankers will sometimes make statements to the effect that a little inflation is a good thing and that deflation needs to be avoided at all costs. From the perspective of an individual, deflation would actually be a good thing. Wouldn’t it be great if the prices of things we want to buy — cars, houses, clothes, stocks, etc. — went down in price?

Yet from the government’s perspective, just the opposite is true: Inflation is a good thing. There are two reasons for this.

First, the government is highly indebted. Officially, the government has more than $17.5 trillion in outstanding debt. However, the debt is actually larger than this because this figure doesn’t follow generally accepted accounting principles insofar as it excludes Medicare and Social Security liabilities. While we don’t know for sure exactly how large the government’s GAAP debt is, even the most conservative estimates place this figure at several multiples of the official number.

Because of this, the government benefits if the value of this debt decreases, and this happens when there is inflation. Inflation causes each dollar to be worth less, and so an indebted entity such as the U. S. government, which has, in effect, a negative amount of dollars, is better off if those dollars are worth less.

Second, inflation causes prices to rise, and the government can tax the nominal gains even if these gains don’t increase the owner’s purchasing power. There are two different scenarios to consider here.

The first is in asset prices. Suppose that the prices of stocks double, but at the same time, the dollar loses half of its value. The net gain to the owner before taxes is effectively zero in that s/he is no better off. While the prices of one’s stocks have doubled, so have his/her expenses. But it is actually worse than this from the point of view of the citizen, because from the government’s perspective, that gain is real and taxable. Thus, even though the citizen’s stock has risen, his or her purchasing power has declined, while the government pockets the difference.

The second scenario is with respect to wages.  Over the long run, we will see wages rise as the dollar loses value. This is a good thing. But we don’t necessarily see the tax brackets rise along with wages and inflation. As a result, while workers may see their wages increase as a result of inflation, they may see their taxes rise if their nominal wages rise sufficiently.

Now this isn’t a big deal if your salary just goes over the threshold of a new tax bracket, since only the amount earned above the threshold is taxed at the higher rate. But as your wage rises with inflation, you will see more and more of your income taxed at the higher rate, and this ultimately pushes you into a higher tax bracket. The winner is the government.

There isn’t much you can do about this, although you can factor these phenomena into your investing. The best way to do this is to figure out the rate at which your expenses are rising and to then determine investments that will not only rise in value faster, but which will increase your purchasing power.

For instance, if you notice that your expenses are about 5 percent higher than last year, you need to target investments that return at least 5 percent after taxes. This means you need to target a return of 6.25 percent on capital gains if you are in the higher tax bracket, or 5.9 percent if you are in the lower tax bracket. As for bond income, which is taxed as ordinary income, you need to determine an appropriate return based on your tax rate. If your income tax rate is 25 percent, then you need to target a return of 6.7 percent.

While this is difficult and unfortunate, it is the reality that we are faced with as investors, and it is better to understand it and be able to react rationally toward it than to ignore it.

More From Wall St. Cheat Sheet: